Confession of a value investor

This is a story about two stocks that I have owned in my as yet brief stint with investing. Let me start with the story of the first one. This is a few years after I had started out, about 15 years ago. The setting was thus. The tech bubble had burst. In the run-up to the bubble, it was the IT sector all the way, with donkeys and horses alike dancing all the way to the sky. There were two other sectors that had a rub-off from information technology (tech) — media and telecom. The three together became the invincible trinity, and were collectively branded TMT by the adoring media. Some people who could not join this song and dance tried their hand at two other sectors, FMCG and pharma. Besides these sectors, every other sector and every company in those sectors were touted as the old economy ‘touch-them-nots’. Once the tech mania fizzled out, as it ought to have, the whole market collapsed, and took the already battered old-economy stocks even further down. It was now hangover time.

Faced with a situation that I had obviously never faced in my life in any capacity, I was like the harrowed citizen of a war-devastated country whose psyche has been terribly bruised. The general mood was such that the very mention of the stock market initiated nausea. I went back to the basic tenets of value investing. After spending much time on books and contemplation, very reluctantly, I started looking out for cheap stocks. Cheap meaning simply cheap, without me really bothering about whether these were good businesses or simply trash appearing cheap. I came up with a few ideas, but didn’t have the heart to go and buy in truckloads. However, I somehow managed to pull the trigger on a few stocks that had a handsome dividend yield, which bordered — or, in some cases, even surpassed — the yield offered by a bank fixed deposit. The sole objective was preserving capital, and the yield on offer somewhat guaranteed capital preservation since the sustainability of already meagre earnings was not much in doubt. At that point, I didn’t know much about different businesses or various industries and the people running the show at respective companies.

Home Run

One of these stocks went on to become a multibagger over the years. And fairy tale-like as it may sound today, it was discovered when I was scanning the newspapers for the lowest P/E stocks (yes, as basic and mundane as that, and that, too, while on a flight to Lugano for a holiday with my wife, who was disgusted with me for working on a holiday; that got me even more petrified). During those years, I went through an extended period of anxiety, lots of circumspection and plain disarray. It was like waiting for this one sparkling day in the whole year when the dividend cheque would arrive in the mail — Teen sau chaunsath andheri raatein aur ek chandni raat. This kept happening for a couple of years. I held on to my conviction on the basis of the checklist suggested by established successful veterans on the subject, like ‘focus on earnings, ignore daily stock price movements’, ‘ignore noise’, ‘investing is like watching the grass grow’ and ‘be greedy when others are fearful’. It’s all very nice to read, but let me tell you that at that time, it all felt like gibberish.

When I had made the investment, besides preserving capital, I had done some numbers for the following three years with very basic assumptions. I concluded that if the stock doesn’t move in three years, it would be at a ridiculous valuation, cheaper than a net-net as suggested by Graham, which is visible today only in case of stocks of companies that are either fraudulent or on the verge of shutting down. So, it would be worth something more in three years than the price I paid; or, alternatively, I completely missed the plot and invested in a company that is going bust.

Over the following two-odd years, the stock almost doubled, and I wiped my sweat, heaved a sigh of relief, and trimmed my position. I surely was not feeling like a partner in the business, but more like a holder of a piece of paper that should be sold as quickly as possible before it again got converted into worthless paper. This despite the fact that in these years, I had learnt much more about the industry and the business, and I still knew that on any valuation parameter, it was still ridiculously cheap. In another two years, it multiplied another ~4x (7x from the original price). I sold more. This time, the valuation was ‘richer’ than in the past, but nowhere near the intrinsic value. I thought the stock had re-rated enough since the valuation had more than doubled. Thereafter, it went into a prolonged period of hibernation. For five long years, it remained within a 20% range. And then, in the next 16 months, it jumped another 5x (35x from the original price).

Long story short, I was lucky to catch this stock cheap, and had the patience to keep holding ever smaller quantities despite market apathy. And that I did for 10 long years. Had I sold it after 9 years, I would have made 7x. I actually held it for 10 years and got 23x. Had I held it for 11 years, it could have been 35x. But hindsight is always 20/20. And ex ante, it’s all a matter of chance, since the difference between 7x in nine years and 35x in 11 years is a vastly different outcome.

I am left with a miniscule quantity till today, which I have buried deep into the ground, in the hope that one day I don’t feel left out when some high-profile money manager proudly proclaims he has a 100-bagger. Today, as I write, it has reached 80x, but I don’t know whether to feel good or bad about it.

Déjà Vu

The next story is about a stock that was the best listed play in that sector at that point. This was in early 2004. This company was the 2nd biggest in its sector, and the sector had been beaten into oblivion for perhaps a decade or so. This company had a strong presence in the markets it operated in, had a good appeal amongst its consumers, its balance sheet was in good shape, and there was a macro tailwind on the horizon. It used to have a profitable book despite it being in a sector where it is not exactly customary to leave anything for the taxman. The best thing was that it was available at book value, with a lot of hidden value in the enormous amount of assets it owned. It had a maze of subsidiaries, associates and JVs. I requested the company for the balance sheets of all these, and the company officials parted with them after a lot of fuss.

This time, it was easier for me to take this call, since I had made some money in the preceding few years, gained confidence and developed some risk appetite. The general market sentiment was also upbeat, and there was a revival in the economy following many years of lull. This idea came to me through someone who later became a friend, and who had been in Mumbai circles for ages. Some relatives and friends talking about the imminent good things the sector was likely to see added to the confidence to take on this somewhat risky idea. The biggest risk was actually the liquidity risk. I had to raise the price by 30% to get the quantity I desired. And the risk was that if the stock languished for another decade, as it did in the previous one, it would have caused me immense price damage to get rid of the entire holding I had accumulated. The other risks were the usual business risk, as also the promoter risk.

Within a year, it became 2x, and in two years, 10x. I kept selling at all levels, and exhausted almost 90% of my holding. It became 250x (no, that’s not a typo) in the 3rd year and 500x (yes, pinch yourself, that is 500) in the 4th. I was oblivious to what was going on as the stock went from circuit to circuit, with rumour mills working overtime, churning out all sorts of stories of promoters consolidating, FIIs buying big time, bonus and splits, vastly improved financial performance and the Big Daddy, an IPO. I couldn’t complain, nor did I bother to verify the truth — or otherwise — in all the market gossip. I sold 10% of my holding at 125x and a fraction of a % holding at 350x.

I got super lucky in more ways than one. First, the stock kept hitting the upper circuit for weeks. So, that made my decision to hold easier, since the buyers were significant, implying a severe shortage of available stock. Second, the company gave a big bonus, and due to some calculation error, I sold more quantity than I possessed pre-bonus. As a result, the stock got auctioned at a much higher price. But by the time the bonus shares were credited to our DP account, the price was far higher than the price at which the short-sold quantity got auctioned. Third, the biggest player in the sector announced its IPO plans at a premium valuation (as is usually the case), which had an understandable rub-off on this stock. All told, it was as if it was God’s own order that all the stars must align to let me make the biggest killing of my career.

Today, the stock is 7x its original price, implying it is down by  more than 95% from its peak of 500x, although 7x in 12 years — if someone had bought it and forgot about it — is still a pretty handsome return. I don’t own a single share today.

Lo And Behold

The first stock is LIC Housing Finance and the second one is Unitech. Both were micro cap back then and both catered to a similar market segment, that is, housing, albeit in very different ways. Both were relatively big players in their respective industries and both had a long runway ahead of them. Let me run you through the subsequent events to determine how robust my thought process was, and any inference that may possibly be drawn from the same.

With respect to LIC Housing, in the 10 years running up to 2011, the company had a lacklustre financial performance during the first five years and a robust and secular performance in the next five. The valuation had gone from 3x to 10x P/E and from 0.4x to 2x P/B. Given the historical valuation, the then prevailing absolute valuation, return ratios, competition getting more aggressive leading to depleting market share, quality of management and the fact that the stock had risen more than 20x, I considered it prudent at this point to sell out completely the balance (almost half of the quantity I originally had). But, since then, a moderate growth in earnings, coupled with a valuation expansion, has led to the stock further quadrupling. Currently, it is quoting at 15x P/E and a little short of 3x P/B. As for Unitech, it was a less arduous journey except for the initial bit, wherein the stock tanked 25% soon after I bought it, as is usually the case. Thereafter, it was a one-way ride, as described above. Within four years, the top line became 8x and profit multiplied 70 times. However, debt grew 60x as well. And this was not for the core operations but for a foray into a totally new and unrelated line of business. This new business was already entrenched with many deep-pocketed players and the economics of the business was suspect. In subsequent years, the company went on an equity-raising spree, before a scam broke out and the company went from one abyss to another. It hasn’t recovered till date, neither in terms of its financial performance, nor its stock price.

Ponder Awhile

The above commentary is a matter of post-mortem. In one case, I seem to have got it wrong, and in the other, right. But this is being too simplistic about the whole thing. When the game is on, a lot many questions need to be answered cumulatively. Will the business fundamentals remain intact? If so, for how much longer? Will any competitive or policy pressure compress margin? Can demand keep growing at a robust pace? Will there be many blips along the way? How might the management handle the same? Or to avoid blips in growth, might the management take shortcuts and repent later?

On the valuation side, who is to say whether the right valuation is 0.5x P/B or 3x P/B? Or if the valuation parameter should be EV/Ebitda or EV/sales or P/E? And, within these parameters, what is the ballpark number close to which a company’s true value lies? It may take more than a decade to go from the lower end of the range to the higher end of the range of any of the aforementioned parameters. Or it may never go at all to the higher end, or may go and start receding to finally settle somewhere in between. It all depends on the mood of Mr Market.

Thus, with so many variables at play, I consider it naïve on part of some money managers to continue holding very richly-priced stocks under the garb of quality. Perhaps it’s about the bigger picture of keeping up their NAV which, in turn, helps them gather ever-larger sums of assets on which they can feast via fees. In such a scenario, it surely helps to never sell stocks, whatever the valuation and with any number of risks attached. But for anyone investing his or her own money, it is advisable to be a seller of even a quality stock at a particular price than cumulatively run the risks as described. I need not illustrate the plight of someone who gets in at peak valuation, only to see it moderate thereafter, even though the company keeps performing well ( for example, HUL). Alternately, for someone who happened to buy at the right price and the company did well but Mr Market remained depressive for half a decade and the investor lost patience and checked out in that period (for example, LIC Housing). Or, the company started performing poorly after a prolonged period of good performance and you happened to get into the stock at that very inflexion point, trying to extrapolate the past well into the future (for example, Bharti).

In the end, your return as an investor is determined by what you buy, the price you pay, the industry doing well, the management riding over a tough period, Mr Market finally deciding to take notice and changing its mood, and you having the tenacity to hold on until such time. To get all these variables right together at the same time is a low-probability event. To attribute it to pure skill without any role of luck would be tantamount to being ‘fooled by randomness’. And it’s surely not as simple as buying something at a good price and going into hibernation. If that be so, it makes a case for Sebi to ban annual recurring fees on old AUMs.

But, strangely, some money managers seem to be actually hibernating in the comfort of their stocks climbing manifold in value, riding on excessive valuation expansion, and still charging an annual recurring fee. Some people get paid to sleep but c’est la vie. And yes, if someone claims to have the divine skill to crystal-gaze and come up with the next 100-bagger, my reply to them would be Vielen danke und haben einen schönen abend (Many thanks and have a nice evening). Or maybe it’s a concoction of blood on the street, accentuated by my wife’s ire, while on a holiday to Lugano. I am going there again in a few months. And, this time, with my children. I hope I am virtually guaranteeing myself the next big idea.

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Wanna Guess This 500-Bagger?

• It was quoted among the lowest P/E stocks in the newspapers

• It was the best listed play, and the second biggest in its sector in early 2004

• There was a macro tailwind on the horizon

• The company used to have a profitable book, but had a maze of subsidiaries, associates and JVs

• It was thinly traded with huge liquidity risk

• The stock was quoting at book value, with a lot of hidden value in the enormous amount of assets it owned

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Bet Right, Get It Wrong Anyway

• HUL: If you bought it at peak valuation, the stock price might moderate over time, even if the company keeps performing well

• LIC Housing: If you bought in at the right price and the company did well for a while but Mr Market remained depressive for half a decade and you lost patience and checked out in that period, you make no money

• Bharti: You will underperform if you bought into the company at an inflexion point — when it starts performing poorly after a prolonged period of good performance — in an attempt to extrapolate the past well into the future

Chaitanya Dalmia, chief investment officer, Renaissance Group